Our Head of Corporate Credit Research explains why the debt of
high-rated EM countries is a viable alternative for investors
looking for high yields with longer duration.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Andrew Sheets, head of
Corporate Credit Research at Morgan Stanley. Along with my
colleagues bringing you a variety of perspectives, today I'll be
talking about why – for buyers of investment grade bonds – we see
better value in Emerging Markets.
It's Friday May 17th at 2pm in London.
This is a good backdrop for corporate credit. The asset class
loves moderation and our forecasts at Morgan Stanley see a US
soft landing with growth about 2 percent comfortably above
recession, but also not so strong that we think we need further
rate increases from the Federal Reserve. Corporate balance sheets
are in good shape, especially in the financial sector and the
demand for investment grade corporate bonds remains high – thanks
to yields, which hover around five and a half percent.
For all these reasons, even though the additional yield that you
currently get on corporate bonds, relative to say government
bonds is low, we think that spread can remain around current
levels, given this unusually favorable backdrop. But we're
less confident about longer maturity bonds. Here, credit spreads
are much more extreme, near their lowest levels than 20 years.
So, what can investors do if they're looking to get some of the
advantages of this macro backdrop but still access higher risk
premiums.
For investors who are looking for high rated yield with longer
duration, we see a better alternative: the debt of high rated
countries in the Emerging Markets, or EM. Adjusting for
rating, high grade Emerging Market debt currently trades at a
discount to corporate bonds. That is for bonds of similar
ratings, the spreads on EM debt are generally higher. And this is
even more pronounced when we're looking at those longer dated
borrowings; the bonds with the maturity over 10 years. In
investment grade credit, you get paid relatively little
incremental risk premium to lend to a company over 30 years,
relative to lending it to 10. But that's not the case in Emerging
Market sovereigns. There, these curves are steep. The incremental
premium you get for lending at a longer maturity is much
higher.
So, what's driving this difference? Well one has been relatively
different flows between these different but related asset
classes. Corporate bonds have been very popular with investors,
enjoying strong inflows year to date. But Emerging Market bond
funds have not, and have seen money come out. Relatively
weaker flows may help explain why risk premiums in the EM debt
market are higher.
Another reason is that the same EM investors who are often seeing
outflows have been asked to buy an unusually large amount of EM
bonds. Issuance from Emerging Market sovereigns has been
unusually high year to date and unusually focused on longer dated
debt. We think this may help explain why Emerging Market risk
premiums are even higher for longer dated bonds.
The good news? Our EM strategy team thinks some of this issuance
surge will moderate in the second half of the year. It's a good
backdrop for high rated credit and this week's CPI number, which
showed continued moderation. And inflation is further reinforcing
the idea that the US can see a soft landing. The challenge is
that – that good news has tightened spreads in the corporate
market.
While we think those risk premiums can stay low, we currently see
better relative value for investors, looking for yield and risk
premium in high-rated EM sovereigns – especially for those
looking at longer maturities.
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